The UK Companies Act of 2006, the Sarbanes‐Oxley Act of 2002, and important reviews of 2009: Implications for the certainty equivalent coefficient net present value criterion

Abstract

Purpose

The purpose of this paper is to draw attention to the fact that the certainty equivalent coefficient net present value criterion, CEC(NPV), in disregarding a fundamental requirement for the calculation of cash flows for purposes of discounted cash flow analysis, invalidates this capital budgeting criterion from the perspective of sound research methodology. The paper also investigates the impact of the UK Companies Act of 2006, the Sarbanes‐Oxley Act of 2002, and important reviews such as the Turner Review of 2009, the Walker Review of 2009, and the Review of the Combined Code of 2009 on this operationally invalid capital budgeting criterion, as well as its impact on the process of financial managerial decision making.

Design/methodology/approach

The CEC(NPV) as a discounted cash flow capital budgeting criterion was examined from the perspective of the axioms of cash flow estimation as well as from the definition of the cost of capital in order to ascertain the contribution of this criterion to financial management. The relevant sections of the UK Companies Act of 2006, the Sarbanes‐Oxley Act of 2002, the Turner Review of 2009, the Walker Review of 2009, and the Review of the Combined Code of 2009 were studied in order to establish whether the CEC(NPV) was able to satisfy the requirements of this legislation and these important reviews.

Findings

The CEC(NPV) is construct invalid and does not measure what it purports to measure: it over‐states financial viability. As a consequence, it does not meet the requirements of sound research methodology and therefore is at odds with the UK Companies Act of 2006, the Sarbanes‐Oxley Act of 2002, and falls foul of the Turner Review of 2009, the Walker Review of 2009, the 2009 Review of the Combined Code issued by the Financial Reporting Council. As such it cannot be endorsed by the Financial Services Authority.

Originality/value

The paper usefully shows that the CEC(NPV) denies financial managers application of Fisherian analysis for resolving conflicts in the rankings of mutually exclusive projects, and, the comparison of project cost of capital with their respective internal rates of return. Comparisons of the internal rate of return, not with the risk‐free rate (that is assumed to be a constant and which exhibits minimal variability in comparison with the cost of capital), but with the cost of capital cost of capital, are a sine qua non for managerial decision making, especially capital budgeting.

Citation

Paulo, S. (2010), "The UK Companies Act of 2006, the Sarbanes‐Oxley Act of 2002, and important reviews of 2009: Implications for the certainty equivalent coefficient net present value criterion", International Journal of Law and Management, Vol. 52 No. 6, pp. 469-480. https://doi.org/10.1108/17542431011093162